This disclosure relates to a computer-implemented system and method for managing custody of financial instruments, in particular, a computer-implemented system and method for mitigating counterparty credit risk exposure in hedge fund transactions.
Derivatives are financial contracts, or financial instruments, whose values are derived from the value of something else (known as the “underlying”). The underlying value on which a derivative is based can be an asset (e.g., commodities, equities, residential mortgages, commercial real estate, loans, bonds), an index (e.g., interest rates, exchange rates, stock market indices, consumer price index (CPI)), weather conditions, or other items. Credit derivatives are based on loans, bonds or other forms of credit.
The main types of derivatives are forwards, futures, options, and swaps, which can be used to mitigate the risk of economic loss arising from changes in the value of the underlying. This activity is known as hedging. Alternatively, derivatives can be used by investors to increase the profit arising if the value of the underlying moves in the direction they expect. This activity is known as speculation.
Broadly speaking, there are two distinct groups of derivative contracts, which are distinguished by the way they are traded in market. Over-the-Counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way. The OTC derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of information between the parties, since the OTC market is made up of banks and other highly sophisticated parties, such as hedge funds. Credit Default Swaps (CDS) are one example of derivatives that are often traded in the OTC derivative market.
Because OTC derivatives may not be traded on an exchange, there may be no central counterparty. Therefore, they are subject to counterparty risk, like an ordinary contract, since each counterparty relies on the other to perform.
A counterparty is a legal and financial term that means a party to a contract. A counterparty is usually the entity with whom one negotiates on a given agreement, and the term can refer to either party or both, depending on context. Any legal entity can be a counterparty. Usually, to say that there are counterparties to an arrangement means that there is some potential for conflict between them. Well-drafted contracts usually attempt to spell out in explicit detail what each counterparty's rights and obligations are in every conceivable circumstance.
Within the financial services sector, the term market “counterparty” may be used to refer to brokers, investment banks, and other securities dealers that serve as the contracting party when completing OTC securities transactions. The term is generally used in this context in relation to “counterparty risk”, otherwise known as default risk, which is the risk of monetary loss a firm may be exposed to if the counterparty to an OTC securities trade encounters difficulty meeting its obligations under the terms of the transaction.
Derivatives are complex instruments devised as a form of insurance, to transfer risk among parties based on their willingness to assume additional risk, or to hedge against it. In spite of their risk, the use of derivatives also has its benefits, because derivatives facilitate the buying and selling of risk, and thus have a positive impact on the economic system. Although someone loses money while someone else gains money with a derivative, under normal circumstances, trading in derivatives should not adversely affect the economic system because it is not zero sum in utility.
In currently implemented financial systems, there can be significant counterparty credit risk exposure in transactions dealing with OTC derivatives. For example, a hedge fund may be exposed to significant balance sheet risk due to the OTC derivative trading counterparty's financial situation, e.g., in the event of bankruptcy of the trading counterparty.
In finance, margin is collateral that the holder of a position in securities, options, or futures contracts has to deposit to cover the credit risk of the counterparty (most often the broker). This risk can arise if the holder has done any of the following—borrowed cash from the counterparty to buy securities or options; sold securities or options short; or entered into a futures contract, for example. The collateral can be in the form of cash or securities, and it is generally deposited in a margin account.
In conventional OTC derivative trades, an initial margin payment is posted directly to an OTC derivative trading counterparty at the inception of the sale, such that a hedge fund is exposed to further risk if the OTC derivative trading counterparty, e.g., a dealer, does not return the initial margin upon maturity or termination of the underlying derivative trade. Furthermore, hedge funds are extremely limited on any investment return on posted margin payments which generally may only earn the so-called “Fed Funds Flat Rate”, resulting in assets that may not provide earnings at a desirable rate.
The International Swaps and Derivatives Association (ISDA) is a trade organization of participants in the market for OTC derivatives. ISDA has created a standardized contract (the ISDA Master Agreement) that counterparties, e.g., hedge funds and dealers, use to enter into derivatives transactions. A Credit Support Annex, or CSA, is a legal document which regulates credit support (collateral) for derivative transactions, and it is one of the optional parts that make up an ISDA contract. A CSA defines the terms or rules under which collateral is posted or transferred between swap counterparties to mitigate the credit risk arising from “in the money” derivative positions (i.e., “in the money” would result in a profitable outcome for those exercising the derivatives). Such terms include thresholds, minimum transfer amounts, eligible securities and currencies, “haircuts” applicable to eligible securities, and rules for the settlement of disputes arising over valuation of derivative positions. A CSA, for example, may address the conditions under which a portion of the initial margin posted to a counterparty may be partially refunded or increased in response to a change in one or more market or economic risk factors.
Another type of margin payment used in OTC derivative trading is “variation margin”. Variation margin or “maintenance margin” is not collateral, but a daily offsetting of profits and losses which is exchanged by counterparties on a daily or intraday basis in order to reduce the exposure created by carrying highly risky positions. By demanding variation margin exchange between counterparties, the counterparties may be able to maintain a suitable level of risk and cushions against significant devaluations in the underlying instrument. FIG. 1 illustrates conventional trading system 100 in which hedge fund 110 posts an initial margin payment to Broker 120 and in which hedge fund 110 and Broker 120 periodically exchange variation margin payments during the life of the trade.
Upon default of the OTC derivative trading counterparty, a hedge fund becomes a general, unsecured creditor, potentially among several general creditors, and may or may not be able to have any of their initial margin payment returned. Although some forms of credit protection insurance are available for protection of the hedge fund, such insurance can be costly and reduce the cost-effectiveness and profitability of the underlying trade.
What is needed is a computer-implemented system and method for mitigating counterparty credit risk exposure which eliminates a hedge fund's balance sheet exposure to an OTC derivative trading counterparty, and which also reduces default risk by providing a new liquidity tool that helps hedge funds manage margin positions and reduce counterparty risk in an uncertain credit environment. What is further needed, for example, is a computer-implemented system and method that allows hedge funds to regain control of initial margin payments in the event of default of the OTC derivative counterparty and to allow posted margins to be maintained by a third party custodian with access to a variety of short-term investment vehicles that are capable of providing a financial return greater than the Fed Funds Flat Rate.